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Will Phibro's Daddy Squash Its Ambitions?

March 24, 1991

Finance

WILL PHIBRO'S DADDY SQUASH ITS AMBITIONS?

Most Americans will never forget the evening of Jan. 16. That's when the U. S. began bombing Iraq in response to Saddam Hussein's aggression. Traders at Phibro Energy Inc. will never forget that night either. In just a few hours, the price of crude oil crumbled, plunging from $32 a barrel to $21. And Phibro, the oil-trading company owned by Salomon Inc., was caught with a huge position in high-priced oil and oil futures. Some traders say Phibro lost about $100 million on that one day. Sources close to the company say it took a $40 million hit.

No need for tears, though--Phibro has just come off a string of fat years. Since 1987, it has been the envy of rivals and the pride of parent Salomon, earning more than $1.1 billion. In 1990 alone, it raked in a stunning $492 million. So despite January's heavy losses and the resignations of a number of traders, including two who sat on the board, President Andrew J. Hall retains the backing of Salomon CEO John H. Gutfreund. "Andy has very acute trading skills. You don't measure the risk business on a one-month time horizon," says Gutfreund, who made his first mark on Wall Street as a bond trader. Says Hall: "Jan. 16 was a freak occurrence--we've never seen anything like it."

Hall may really run into trouble, though, in carrying out his ambitious expansion plans. Over the past five years, Phibro has built on its oil-trading prowess by diversifying into refining and shipping as well as offering new financial products to minimize the risk of fluctuating energy prices. Hall wants to expand so that Phibro will take oil from the ground to the gas station. "We could have the scope to become a sizable energy company in all facets of the business," says Hall. But Gutfreund is a tough sell. He may not want to put big money into businesses that take the company far afield. "We are not betting the ranch," says Gutfreund of a recent Phibro investment in a joint oil-producing venture in the Soviet Union.

There has even been some discussion at Salomon about spinning off Phibro. It has about 780 trading and corporate employees and 1,220 refining and drilling employees worldwide, compared with Salomon Brothers' 6,700 employees. As a separate company, Phibro could make acquisitions by issuing stock instead of going to Salomon for capital, say sources close to Phibro. But Gutfreund thinks they're better off under one roof. "We're not presently considering splitting the companies," he says.

Despite Phibro's diversification, oil trading is still the core. It earned $369 million in 1990's third quarter after Iraq invaded Kuwait and the price of oil soared. A big chunk of that came from a huge position that Phibro had taken in June and July to take advantage of an anomaly in the futures market. About 95% of the time, crude oil trades for less in the forward market than it does on the spot market. But in June, as tensions in the Mideast started to heat up, prices of forward contracts, which commit the seller to deliver oil at a set price and time in the future, were trading at some $2 above the spot price of $14 a barrel.

Hall pounced: He bought about 25 million barrels of North Sea and similar oil at about $14 a barrel and sold North Sea forward contracts that committed Phibro to deliver oil in September for about $16 a barrel. Then, Hall put the $14 oil in storage all over the world, including three full tankers that dropped anchor in the Gulf of Mexico.

SURE THING. Phibro couldn't lose. If prices rose by September, it could make delivery on its forward contracts with its stored oil. If prices fell, the loss on its stored oil would be more than offset by its short position at the higher price. In fact, says Hall, Phibro had locked in a profit of about 50~ a barrel after shipping, storage, and insurance costs.

By Aug. 2, when Iraq invaded Kuwait, oil had soared to about $26 a barrel. But the price of the forward contract rose to only $24, flipping the market back to its more normal pattern in which future prices trade below current prices. Phibro was able to sell the $14 oil out of storage for $26--a $12 profit. Then it bought back its $16 forward position for $24, for a loss of $8 a barrel. The result: a profit of $4 a barrel, or roughly $100 million before transaction costs.

Few energy companies could have managed such a trade. With its ship-chartering business, Phibro was able to take delivery of stored oil. It was also able to find cheap storage space--a key element in initiating the trade. The deal represents Hall's trading philosophy, which is geared toward a rising oil market: "We like trades where there's lots of upside and limited downside."

Phibro does other kinds of complex "spread" trades as well. These take advantage of the differences in, say, the prices of spot oil and oil futures. Spreads also arise among the 60 different grades of crude oil from the North Sea to West Texas Intermediate, different futures contracts that expire in different months, the different prices oil commands at various locations, and the variety of oil products.

Phibro has its own network of information. Its traders all over the world continually feed information to a central computer on who bought what, where, and at what price. "We're trying to find anomalies where something is sold too cheaply in relation to its relative value," says Hall. "Then we lock in the discrepancy through hedging."

But the refining business is what really sets Phibro apart from its Wall Street competitors. On average, about 30% of revenues comes from refining, according to one analyst's estimate. Refining profits depend largely on the size of crack spreads--the difference between the price of crude oil and refined oil products, such as gas or heating oil. Refining has also helped Phibro win a number of contracts with oil-producing countries. The ability to take delivery of 3 million to 4 million barrels of oil a day gives it another alternative to reselling crude oil purchased in the spot markets. It can refine the crude oil and sell jet fuel, for example. And since its traders are getting calls from people who want to buy, say, heating oil, it gives them insight into whether the market is temporarily out of line. Phibro's "biggest advantage is being extremely plugged into the cash market," says Jack Barbanel, CEO of First Global Asset Management.

Phibro is also a major player in the estimated $30 billion energy-derivatives business. Energy-derivatives are privately issued contracts that let companies minimize the risk of wildly fluctuating energy prices. One example is swap contracts. For a fee paid to Phibro, a swap may allow a cruise-ship company to lock in a $14 fixed price for 1 million barrels of high-sulfur oil for a year. At the end of every month, if the spot price of the oil is, say, $15, Phibro pays the cruise line $1 a barrel. If the price is $13, the cruise line pays Phibro $1 a barrel, thus swapping the floating market price of oil for a fixed rate. Banks, Wall Street firms, and the big oil companies are now battling Phibro for this growing market.

Phibro started out as a unit of Philipp Brothers Cos., the former giant international commodities company that traded everything from coffee to rubber. In 1981, Philipp bought the Wall Street partnership of Salomon Brothers Inc. In 1983, Phibro Energy was formed as a separate subsidiary of Philipp.

By 1985, Wall Street had discovered the world oil markets. Rivals such as Goldman, Sachs & Co., with its J. Aron division, and Morgan Stanley Group Inc. piled into the trading end of the business. But Phibro went further: From 1985 to 1988, it bought four refineries in Texas and Louisiana with more than 300,000 barrels of daily refining capacity, which made Phibro the fourth-largest independent refiner in the U. S.

In 1986, Gutfreund won control of Philipp Brothers. Phibro-Salomon Inc. became Salomon Inc. At yearend 1990, Phibro Energy was the only part of Philipp still extant. Because of large losses, Philipp's nonenergy businesses were absorbed into Salomon, which cost that firm a hefty $155 million restructuring charge in 1990. The refineries, which cost Phibro $100 million, are now worth about $1 billion.

LEGENDARY STATUS. While the push into refining started before Hall's tenure, most accounts give him much of the credit for Phibro's success. One sure sign of Gutfreund's appreciation is Hall's 1990 bonus of an estimated $20 million and his December, 1990, promotion to Salomon's 12-person board. Hall, a tall, intense British citizen with an MA in chemistry from Oxford University, spent nine years at British Petroleum Co. in London and New York before starting at Phibro in 1982. On weekends, Hall unwinds at his dairy farm in Vermont. Within Salomon, Hall approaches the legendary status of John Meriwether, the bond trader who is said to have challenged Gutfreund to a $10 million game of liar's poker.

Neither Gutfreund nor Hall expects 1991 to be as spectacular as last year. Phibro could even post losses for the first quarter, depending on whether it uses reserves set aside during better times to offset losses, say market sources. And if oil slumps to $10, it could weigh heavily on Phibro's trading profits. No way, says Hall. He sees oil ranging from $18 to $22. From domestic producers to the Saudi government, "no one wants $10 oil," he notes.

Perhaps. But as a trader, Hall knows that what people want is not always what the market delivers.HOW PHIBRO ENERGY BOOSTS

SALOMON'S BOTTOM LINE

Pretax income*

Millions of dollars

1986 1987 1988 1989 1990

SALOMON BROTHERS $796 $253 $513 $534 $416

PHIBRO ENERGY 30 60 227 375 492

PHILIPP BROTHERS -3 52 48 -116 -168

TOTAL PRETAX INCOME* 823 365 788 793 740

*Excludes losses due to nonrecurring special items and corporate expenses of

$30 million in 1986, $140 million in 1987, $35 million in 1988, $53 million in